Abstract
This note examines the efficiency gains that might result from market-based debt reduction and alternative uses of resources. It is argued that when a country’s expected output falls short of contractual claims on that output, private investment is drawn to activities that protect the investors’ share of future output at the expense of activities that increase future output. Resources provided by a third party could reduce this gap through market-based debt reduction or by supporting government investment or consumption. Given considerable uncertainty about the efficiency returns of alternative uses of resources, it seems likely that an optimal strategy would include both debt reduction and government investment.
I. Introduction
It has been argued that debt reduction through voluntary market-based transactions is unlikely to be the best use of resources for a debtor country. 1/ The argument is simple and powerful. A discount in the secondary market for existing debt means that the expected present value of payments on that debt are below the contractual value of the debt. If both debtors and creditors have the same expectations and are risk neutral, the best the debtor can do is reduce expected future payments, discounted at a risk-free rate, at the sacrifice of giving up an equivalent present value of the resources used in the buy-back. 2/ Since returns on new investment in the debtor country will, in part, go to existing creditors, it can be presumed that there exist investment opportunities that yield a risk-adjusted return to the debtor government which is higher than the “world” interest rate. In a sense the debtor government can “get around” the market inefficiency generated by debt contracts that are interdependent by investing in real capital or reserves. It follows that the best use of funds is probably to be found in domestic government investment rather than market-based debt reduction.
An important element of this argument is that the benefits of debt reduction are fully captured by the reduced value of expected payments to creditors associated with debt reduction. This measure of benefits may be appropriate in the context of a bilateral debtor-creditor framework, but is less convincing if there are multiple creditors. 3/ In a bilateral context, the rights of creditors vis-à-vis one another do not affect their behavior. Only the rights of the creditor relative to the debtor are important. As an example, it is difficult to see what difference the contractual value of debt could make to either party’s behavior when the entire debt is very unlikely to be serviced. If the debt now sells at a 60 percent discount, the expected value of a bond is contingent upon the debtor’s economic performance even though the financial contract is not a contingent claim. If, for example, both the debtor and creditor expect that there is zero probability that payments with a present value of more than 80 percent of contractual value will be made, it is clearly foolish for the debtor to pay an average market price of $0.60 (or higher) in order to retire the marginal 20 percent of the debt. The debtor would be better off to keep the resources and invest in reserves or domestic activities. 4/
There are, however, many claimants to a debtor country’s future output. Moreover, very few of these claims are explicitly contingent on outcomes for the debtor’s economic performance (other than for domestic inflation). In general, financial contracts and labor contracts are not contingent on output in the future; particularly in developing countries where private equity markets are very small. If, in the future, the collective contractual claims on output exceed what is available, the government and/or the legal system and private bargaining will determine a distribution. 5/ In this context the rate of return to debt reduction or alternative investments is not limited to the direct reduction in future debt-service payments or direct yield on the alternative government investments. An additional return is possible since either use of resources contributes to economic efficiency by eliminating/ reducing nonproductive activity. Alternative investments would reduce incentives for nonproductive activity by increasing the expected value of future output relative to an unchanged debt stock. It is, however, difficult to insure that resources are utilized at the margin for government investment that has this effect. Debtor governments might face substantial difficulties in identifying and carrying out investment projects that are as productive as those identified and carried out by the private sector in response to a reduction in contractual claims on future output. Moreover, in many cases debtor governments are attempting to increase the role of markets in resource allocation; debt reduction might play an important role in reinforcing these initiatives. Thus, debt reduction might be preferred in cases where the debtor government wishes to improve the incentives for private investment.
The key to the argument is that residents of the debtor country and other creditors will change their behavior once they recognize that future output is likely to be inadequate to meet all of the collective contractual claims on it. The expected value of any contract is, under these circumstances, contingent on two considerations. The first, of course, is the expected range of outcomes for the value of the debtor country’s output. The second is the expected distribution of that output. In the future some government and institutional framework in the debtor country will allocate output among the country’s creditors. The creditors include domestic labor and the domestic owners of capital as well as external creditors. But how will this allocation be made? How will the priorities be established and by whom?
An important aspect of this problem is the reduced effectiveness of the institutions that have evolved in market economies to minimize what have been called “ex post transactions costs.” The problem is clearly presented in Williamson (1985).
“Thus suppose that the contract stipulates x but, with the benefit of hindsight (or in the fullness of knowledge), the parties discern that they should have done y. Getting from x to y, however may not be easy. The manner in which the associated benefits are divided is apt to give rise to intensive, self-interested bargaining. Complex, strategic behavior may be elicited. Referring the dispute to another forum may help, but that will vary with the circumstances. An incomplete adaptation will be realized if, as a consequence of efforts of both kinds, the parties move not to y but to y’.”
An important implication of this line of argument is that the institutional framework or industrial organization that has evolved in market economics can, in large part, be understood as successful mechanisms for minimizing such costs. Moreover, such institutions have been put in place slowly as market economies have themselves developed. It follows that many debtor countries face a dual problem. First, structural reforms are being put in place that allow market forces a greater role in organizing economic activity. Even in the most favorable circumstances, this would require a rapid development of market-oriented institutional arrangements. But the problem of developing such institutions in circumstances where the mutual inconsistency of existing contracts provides substantial gains from opportunistic behavior must be very difficult.
The uncertainty about the value of contractual claims on future output leads to predictable changes in behavior. We should expect investors and workers to utilize resources to position themselves in order to extract future income from one another. In equilibrium, resources will be wasted in order to equalize the expected return on rent-seeking and productive investment. It is often argued that weak economic performance in debtor countries reflects institutional frameworks in which privilege and corruption distort market forces. The argument developed here suggests it is the other way around: debt overhang generates private incentives to undermine the existing institutional rules of the game governing the distribution of future output.
This is an example of a negative sum game because efforts to increase shares are, to some extent, offset by others with a net cost to the community. The hidden costs of protecting wealth are difficult to measure; this might explain why apparently highly profitable marginal investments in debtor countries are not carried out and why private capital outflows are a problem for most debtor countries. Investment opportunities with lower rates of return, but also that are more easily concealed, moved, or quickly amortized will be favored.
Returning to the evaluation of debt reduction, it might be helpful to consider two uses of resources available to debtor governments. A debtor government can accumulate reserves, and directly subsidize or engage in domestic investment, or it can, through debt reduction, reduce the incentives for rent seeking. It seems unlikely that we know enough about either policy to be confident which will be preferred in a specific case.
How to attack this problem?
The ideal way to attack the problem of excessive contractual claims on future output would be a comprehensive settlement that would restructure and reduce existing claims. In fact, Fund-supported adjustment programs attempt to accomplish this. Adjustment programs typically involve adjustments in real wages, real exchange rates and fiscal reform designed to place the debtor country in a better position to meet competing claims on national output. Directly reducing the contractual value of financial claims on future output would seem to complement the adjustment effort. Moreover, reducing the value of aggregate contractual claims can be expected to reduce the value of unproductive efforts to protect property rights and in this way directly increase expected future output.
A conventional prescription when there are competing claims for output is that financial contracts, most of which are not contingent, should be honored. This means, of course, that other contracts, for example wage contracts, must be adjusted to absorb the shortfall in output. But it may be very difficult to accomplish the necessary reduction in other claims without a fall in output.
A part of the problem is that important relative prices change immediately by amounts that reflect expectations about the government’s ability (or willingness) to honor its own financial contracts. The lack of confidence creates incentives for capital flight, thereby depreciating the domestic currency to a level consistent with a substantial transfer of domestic savings to foreign countries.
In turn, the fall in domestic investment could generate a business cycle downturn. The lower level of output makes it even less likely that financial liabilities of the debtor government can be fully serviced. The result is severe difficulty in attracting or retaining capital, a substantial (and prolonged) real exchange rate depreciation, a low level of output and little actual amortization of government debt. 6/
This “bad equilibrium” is consistent with the financial market’s view that the government will not succeed in maintaining the value of financial assets. Such a view is probably most relevant in countries where servicing debt becomes the responsibility of the government, that is, in those countries where private debt is routinely guaranteed by the government. But this, unfortunately, has become all too common both in industrial and developing countries alike. In developing countries, external debt has been routinely guaranteed by the government. Perhaps equally important, the governments of developing countries have also, in practice, acquired the assets of domestic commercial banks and non-financial corporations made insolvent by real exchange rate depreciations and economic recessions.
A related possibility, emphasized by Calvo (1990), is that the terms on which residents will lend to the government deteriorate with the expectation that the financial liabilities of the debtor government will fall in value. Furthermore, this becomes a self-fulfilling and, therefore, “rational” expectation. Other interesting papers by Dornbusch (1988) and Blejer and Ize (1989) also emphasize the interdependence of private investment decisions and the very difficult task faced by a debtor government in maintaining credible economic policies. Each of these models will have different implications for the relative efficiency of allocating resources to debt reduction as compared to government directed or subsidized activities. In the face of considerable uncertainty about the relative merits of debt reduction and public investment, it would appear prudent to diversify support for these alternative policies.
References
Blejer, Mario I., and Alain Ize, “Adjustment Uncertainty, Confidence, and Growth: Latin America After the Debt Crisis,” IMF Working Paper, WP/89/105 (Washington: International Monetary Fund, December 1989).
Borensztein, Eduardo, “Debt Overhang, Credit Rationing and Investment,” IMF Working Paper, WP/89/74 (Washington: International Monetary Fund, September 1989).
Bulow, Jeremy, and Kenneth Rogoff, “The Buy-Back Boondogle,” Brookings Papers on Economic Activity, 2, The Brookings Institution (Washington, 1988).
Calvo, Guillermo, “On the Costs of Temporary Policy,” Journal of Development Economics (Amsterdam), Vol. 27 (October 1987).
Calvo, Guillermo, “Controlling Inflation: The Problem of Non-Indexed Debt,” IMF Working Paper, WP/88/29 (Washington: International Monetary Fund, March 1988).
Dooley, Michael P., and Peter Isard, “Country Risk, International Lending and Exchange Rate Determination,” International Finance Discussion Papers No. 221, Federal Reserve Board of Governors (May 1983).
Dornbusch, Rudiger, “Notes on Credibility and Stabilization,” NBER Working Paper No. 2970 (Cambridge, Massachusetts: National Bureau of Economic Research, December 1988).
Dornbusch, Rudiger, “Economic Reconstruction of Latin America,” (unpublished, Massachusetts Institute of Technology, November 1989).
Froot, Kenneth, and Paul Krugman, “Market-Based Reduction for Developing Countries: Principles and Prospects,” (unpublished, Massachusetts Institute of Technology, January 1990).
Krugman, Paul, “International Debt in an Uncertain World,” International Debt and the Developing Countries, ed. Gordon W. Smith and John T. Cuddington, IBRD, (Washington, DC, 1985), 79-100.
van Wijnbergen, Sweder, “Cash/Debt Buy-Backs and the Insurance Value of Reserves,” Journal of International Economics, (forthcoming, 1990).
If debtors face credit rationing, the return to reserves exceeds the risk-free rate so that debt reduction will always yield a rate of return below that on foregone reserve assets. See van Wijnbergen (1990).
There are, of course, other possibilities. The debtor government might expect to make higher payments than what is implied by market prices. Moreover, as argued in Dooley, Symansky, and Tryon (1989), a buy-back or an alternative debt or debt-service reduction program might provide an efficient mechanism for renegotiating existing contracts.
This argument can be found in Dooley (1989) or, more carefully exposited, in Bulow and Rogoff (1989).
This is, of course, always the case to some extent, but the extent of government intervention in distribution is normally limited and well-defined ex ante. Moreover, it is argued below that the institutional framework in market economics minimizes the costs of private bargaining.
See Dooley and Isard (1989) for a formal model.